Economic Control or Reform or Structural Change : Occupy the 1?
Article of The Month Economic Control or Reform or Structural Change In gloomy days, people seek for hope. The world where global growth will be powered by of financial markets is in a critical junction with emerging economies, rather than held back by its economies long battered by the worsening them. In this current world economy the euro crisis. While chunk of investors ventured emerging markets are not at all secluded from out from safe‐haven bonds into riskier assets; financial shocks those have been occurring concurrently, stock prices are bumping and especially since 2007‐08 crises or even ahead of America’s economy is limping along and the that in the advanced economies of the world. In summer slump in share prices while consumer most cases, emerging economies with no fault spending has been forecasted to go weak. On of their own face twisting troubles to run their this very moment world’s decision makers are economy smoothly at the time of financial crisis yet to finalize a concrete way out or an effective in the advanced economies. In practice, the strategy towards sustainable long‐term central banks of emerging markets ensure recovery. Still the world citizens are waiting for themselves through buying bonds from a direction with deep hope. This paper is going advanced economies which in turn cause the to discuss some of the latest hot talks around emerging markets to run with deficit budget. the globe and precisely about the risks of This deficit in the emerging markets is financed current global financial systems and operations. by taking loan from their commercial banks Firstly, the main problem of the current global creating liquidity crisis and slow growth financial system has been discussed in light of prospect for the respective country. To solve contemporary phenomenon. And how the this dilemma, global liquidity insurance has central banks of different economies and the been suggested and it would force a quicker overall global financial system interacts adjustment of global imbalances instead of the between them and what duties are binding the Bretton Woods system that prevails in global central banks to keep respective economies off economy currently. In the above mentioned the heat of global financial risks or meltdown. current financial system exists globally, central Afterwards, this paper has presented evidence banks act as the fiscal agents of respective of risks from current financial risks and how it governments. They also issue notes to be used has hurt the economies of the world, both at as legal tender, supervise the operations of the large economies as well as at emerging ones. commercial banking system, and implement Later paragraphs discusses on a paper monetary policy. By increasing or decreasing the presented by a Professor. Lately in Aug (2011), supply of money and credit, they affect interest Cornell University’s Eswar Prasad (Prasad), the rates, thereby influencing the economy…Their Tolani Senior Professor, offered a fresh road aim is to maintain conditions that support a high map to reform the international monetary level of employment and production and stable system. He argued that emerging markets domestic prices. Central banks also take part in should be protected from financial shocks cooperative international currency through a global insurance scheme rather than arrangements designed to help stabilize or by “self‐insuring” through purchasing regulate the foreign exchange rates of government securities of the advanced 1 participating countries. economies. All Financial Institutions (FIs) and commercial Current Global Financial System banks of any country are licensed and insured Despite the current economic turbulence, the by respective central banks in this process. emerging markets are going through some rapid These banks and FIs keep deposit and buy growth. In future we are moving into a world government treasury bill/bond from respective 2
central banks. Whereas the central banks of growth rate. Inflation makes life costlier and emerging markets are insured through buying slower pace of industrialization adds more and bond from the advanced economies central more unemployed people to these economies banks i.e. Federal Reserve System. In the every year. So in today’s world economy World current arrangement, the central banks of Bank and IMF (International Monetary Fund) advanced economies can easily avail pull of debt plays the role of financial facilitator along with through selling government bonds to the central Central Banks. If we look back the emergence of banks of emerging economies incurring very low World Bank and IMF it all started from the cost of fund to finance their huge budget deficit ‘Bretton Woods System’. every year. Through this process the advanced markets have already taken a huge debt making The Role of World Bank and IMF them overburdened. For example, Currently This Bretton Woods system of monetary Italy has 120% debt of their total GDP and which management established the rules for is the highest in the world. This high level of commercial and financial relations among the public debt has even increased the cost of world’s major industrial states in the mid 20th public borrowing of such countries, slowing century. The Bretton Woods system was the down the country’s growth rate (to 0.3% in Italy first example of a fully negotiated monetary and also one of the lowest in the world). In this order intended to govern monetary relations regard EU has gathered bailout fund to protect among independent nationstates… Setting up a the slumping economies (i.e. Greece, Italy, system of rules, institutions, and procedures to Ireland and Portugal). But this process cannot regulate the international monetary system, the go on. On the other hand, unlike developed planners at Bretton Woods established the IMF economies, emerging economies finance their and the International Bank for Reconstruction budget deficit through taking loans at a much and Development (IBRD), which today is part of higher rate from their own commercial banks the World Bank Group. These organizations creating liquidity crises in the economy. These became operational in 1945 after a sufficient commercial banks keep required deposits in the number of countries had ratified the agreement. central banks at a much lower rate whereas The chief features of the Bretton Woods system they collect deposits from the households and were an obligation for each country to adopt a institutions at a significantly higher rate due to monetary policy that maintained the exchange lesser and lesser flow of money in the rate by tying its currency to the US dollar and economies resulted from everlasting and the ability of the IMF to bridge temporary increasing budget deficit every year. Again, 2 imbalances of payments . These organizations emerging countries require huge fund from the were established with different aims. According Bretton Woods organizations (WB, IFC) for to the World Bank, “The World Bank is a vital different development projects they undertake source of financial and technical assistance to for infrastructural improvement in their own developing countries around the world. Our countries. These economies take huge loan from mission is to fight poverty with passion and the organizations at a high cost of fund. From professionalism for lasting results and to help every aspect they are bound to take the fund as people help themselves and their environment they lack the same due to injecting fund in by providing resources, sharing knowledge, buying bonds of advanced economies to insure building capacity and forging partnerships in the respective countries economy or financing their 3own deficit budgets. Consequently, above public and private sectors.” incidents those take place in the emerging The World Bank offers a wide range of lending economies lead the banks and FIs of emerging and non‐lending solutions to meet the world’s markets lending money to their customers (both development challenges i.e. investment and corporate and retail users) at a much higher rate development policy operations, banking than any developed a country. This high cost of products, trust funds and grants, guarantees & fund affect the emerging economies even worse non‐lending activities etc. On the other wing, than before causing both Inflation and slower according to IFC, “IFC, a member of the World Bank Group, is the largest global development 3
institution focused on the private sector in economy bonds. Some economies limit their developing countries. We create opportunity for sterilization costs through financial repression. people to escape poverty and improve their Such insurance may also prove expensive in the lives. We do so by providing financing to help long run in terms of an eventual capital loss businesses employ more people and supply from the anticipated depreciation of advanced essential services, by mobilizing capital from economy currencies relative to those of others, and by delivering advisory services to emerging markets or if advanced economy US Bond sold to Selected Countries in 2011 [Billions of USD] Country Mar 2011 Apr 2011 May 2011 Jun 2011 Jul 2011 Aug 2011 China (main) 1144.9 1152.6 1159.8 1165.5 1135.3 1137.0 Brazil 193.5 206.9 211.4 207.1 210.0 210.0 Taiwan 156.1 154.5 154.4 154.4 154.3 150.3 Russia 127.8 125.4 115.2 110.7 100.7 97.1 India 39.8 42.1 41.0 38.9 37.9 37.7 Source: Department of the Treasury / Federal Reserve Board. Oct 18, 2011 4 governments drive down the real value of their ensure sustainable development.” IFC provides 5investment services, advisory services and asset bonds through inflation. Accounting all these management services to their clients in prevailing problems in the global economy, the emerging markets. Both organizations also current system needs to be improved through ensure guidance and accountability throughout taking several measures. the project implementation. Any discrepancy of agreement regarding diversification of fund, Global insurance scheme can be used as a role meeting time limit, use of resources, corruption reversal of the current financial system. This etc may lead to termination of contract. system has been talked by both Prashad, senior professor of Cornell University and IMF. Prasad’s ‘Global Insurance System’ Prasad’s insurance scheme would provide a According to Prasad at heart it is a really simple safety net for countries that run into trouble idea, till now, the issue hasn’t been framed this because of global shocks, often through no fault way, and most people have simply looked at of their own. This scheme would also require tweaking the existing financial system. But there countries with higher risk to pay higher is a lot of institutional baggage out there that premiums up front, when they need the payout, makes emerging markets reluctant to rely on no new strings would be attached to the money. the IMF, even though the IMF is supposed to The plan would provide a temporary respite for offer protection to emerging markets. His countries with deep fiscal problems. According scheme strips the problem down to its bare to Prasad, global liquidity insurance scheme essentials and what the solution ought to be. suggests possible solution that would provide a His proposed ‘Self‐Insurance System’ that safety net for countries that run into trouble prevails in the current global financial system because of global shocks, often through no fault tends to be costly for emerging markets that of their own and a quicker adjustment of global have to tie up resources in advanced economy imbalances. This scheme would also require government bonds rather than using it to meet countries with higher risk to pay higher their own physical capital investment needs. premiums up front, when they need the payout, Another cost involves the higher yields paid on no new strings would be attached to the money. government bonds used to sterilize the liquidity The plan would provide a temporary respite for effects of foreign inflows relative to the low countries with deep fiscal problems. The major yields earned on reserves held as advanced risk emerging markets face from rising financial 4
openness is no longer related to dependence on mainly but not necessarily just for the emerging foreign finance, but arise because capital flows markets. Each country would pay a modest heighten homegrown vulnerabilities and entry fee between USD 1 and 10 billion, exacerbate the costs of weak domestic policies depending on its size as measured by GDP, to and institutions. Again, in the current system provide an initial capital base. It would then pay the developed economies can finance its large an annual premium for buying insurance that it budget deficit by selling government bonds at a could call upon in the event of a crisis… A much lower rate as to the emerging economies country running large budget deficits or those insure themselves against financial crisis. continuing to accumulate large stocks of But Prasad’s plan would force the developed external debt in successive years would pay economies to be disciplined in their fiscal rising premiums in each of those years. In this policies and control their budget deficits along way, their contributions to rising global risks with reducing the demand for US or EU 8 would be accounted for. The premiums 6government bonds by the emerging markets. accumulated through the above mentioned Prasad includes, emerging markets have cast off process would be invested in a mixed portfolio their original sin – their external liabilities are no of government bonds of the US, Euro area and longer dominated by foreign‐currency debt and Japan. In return, the Federal Reserve, ECB and have shifted sharply towards direct investment Bank of Japan would be obliged to backstop the and portfolio equity. Their external assets are pool’s lines of credit in the event of a global increasingly concentrated in foreign exchange crisis. This would simply institutionalize ex‐ante reserves. Given the deteriorating public debt swap arrangements of the sort that major trajectories of reserve currency economic areas, central banks opened up ex‐post during the the long‐term risk on emerging markets’ crisis to provide liquidity to other central banks. external balance sheets is shifting to the asset The insurance payout would be in the form of a side. Still, emerging markets are looking for credit line open for a year rather than an more insurance against balance of payments outright grant. The interest rate would be non‐crises even as adverse debt dynamics in punitive and based on the yields on short‐term advanced economies increase the potential government securities in the countries backing costs of self‐insurance through reserve up the insurance pool. The country drawing on accumulation. Prasad proposes a mechanism for this insurance would be required to pay back global liquidity insurance that would meet this the borrowed amount within the one‐year need with fewer domestic policy distortions and period in the same hard currency that it gets for force a quicker adjustment of global imbalances. the loan. So if a country’s currency depreciated It also argues that the big risks most emerging in the ensuing year, it would have a higher debt markets face from rising financial openness are burden in domestic currency terms, which to no longer related to dependence on foreign some extent would be a disincentive for the finance but arise because capital flows heighten country to persist with bad policies under the home‐grown vulnerabilities and exacerbate the protection provided by the credit line. The costs of weak domestic policies and country would not be able to buy additional 7 insurance until there was a full repayment of institutions. To make the short term solution work, Prasad has also suggested required the initial draw from the insurance pool. reserve that would be desirable to keep by the Premiums would be raised substantially if a emerging economies. Conventional criteria country wished to renew its insurance in the suggest a level adequate to cover 6 months of next period after drawing on the credit line imports or the stock of short‐term external debt without any improvements in its policies. Thus, maturing over the next year (the Greenspan‐ the insurance would only be suitable for Guidotti rule). By these criteria, most major liquidity crises. This system would also bring emerging markets had accumulated more than broader benefits i.e. help discipline advanced sufficient reserves by the early 2000s. The economies’ fiscal policies by raising their insurance pool suggested by Prasad for the borrowing costs. This would also tamp down world’s major economies would be formed— private capital flows to emerging markets, an 5
added benefit for those countries in that group the banking system, said Ajai Chopra, the concerned the low cost debt in the US and other deputy director of the IMF’s European advanced economies is flowing Department. The IMF believes a deposit disproportionately to them and causing insurance scheme should be introduced in complications in their domestic macroeconomic parallel to an increased harmonization of management. This scheme would help get the deposit insurance schemes in the member incentives right. First, it reduces the incentives states to ensure sovereign problems don’t for emerging market economies to selfinsure; in trigger destabilizing bank runs, he said. The the event of a liquidity crisis, they would have scheme could be funded by a harmonized bank access to a large insurance pool with no levy on selected bank liabilities or a financial conditions attached. This would allow them to 9 activity tax, he said . Limitation No model can conduct better macroeconomic policies rather perfectly capture all the idiosyncratic factors than focus on accumulating reserves. Second, it that will constrain or boost an economy’s mitigates the risk of spiraling global development of the world overnight. One of the macroeconomic imbalances and the attendant most significant matters regarding this risks of crises and their spillover effects. Third, it proposed model is, re‐investment of the fund in creates a transparent mechanism by which the developed economy, as said, ‘the premiums global costs of a country’s policies would be accumulated through the above mentioned internalized to some extent or, at a minimum, process would be invested in a mixed portfolio made more visible. Lately, IMF proposed an ‘EU‐ of government bonds of the US, Euro area and wide deposit insurance scheme’ who called for a Japan’. Prasad’s theory of re‐investment of the scheme a more coordinated regulation of the fund in the developed economy is in contrast, to continent’s banks to prevent contradictory the idea that, if the developed countries fail, the national regulation from exacerbating its debt developed country’s bonds won’t help crisis. It will work as a common bank crisis protecting the economy of the emerging management system, a supra‐national countries. resolution regime and common deposit insurance rules would help significantly stabilize Endnotes: An Article by: 1. http://www.answers.com/topic/central‐bank Aziz, Monsurul (2011); Officer R&D, MTB 2. http://en.wikipedia.org/wiki/Bretton_Woods Jahan, Afsana (2011); Senior Officer R&D, MTB 3. http://web.worldbank.org/wbsite/external/ Farukh, ANM (2011); Head of R&D, MTB 4. http://www1.ifc.org/wps/wcm/connect/ 5. http://prasad.dyson.cornell.edu/doc/ Contact: 6. Ibid 7. Ibid 8. Ibid 9. http://articles.economictimes.indiatimes.com 1 www.mutualtrustbank.com/info_mtbiz.php 2 3 4 5 6 7 8 9 6